ProfessorBainbridge.com

What is a "de jure" corporation, and how is it different from a "de facto" corporation according to the US law?

I answered the titular question over at Quora, as follows:

“A de jure corporation is ordinarily thought of as one which has been created as the result of compliance with all of the constitutional or statutory requirements of a particular governmental entity. … A de facto corporation, on the other hand, can be brought into being when it can be shown that a bona fide and colorable attempt has been made to create a corporation, even though the efforts at incorporation can be shown to be irregular, informal or even defective.” Harris v. Stephens Wholesale Bldg. Supply Co., Inc., 309 So. 2d 115, 117 (Ala. Civ. App. 1975).

The distinction arises because corporation statutes provide limited liability only to validly formed corporations (i.e., “de jure corporations”). A defectively incorporated business could be viewed as a partnership or sole proprietorship, neither of which confer limited liability on their owners, rather than a corporation.

Defective incorporation was a fairly serious problem decades ago when incorporating a business involved far more technicalities than it does today. Older corporation statutes required compliance with substantial procedural formalities as a condition of incorporation, such as multiple local filings, notice by publication, minimum capital requirements, and the like. It was easy for some minor glitch in the incorporation process, such as failing to file all the requisite documents or failing to do so in all the requisite offices, to prevent the corporation from coming into existence as a legal entity.

The most widely used standard for invoking the de facto corporation doctrine is whether (1) there was a good faith effort to incorporate the business and (2) the putative shareholders carried on the business as though it were a corporation, especially with respect to the transaction in question. In Cantor v. Sunshine Greenery, Inc.,[1]for example, the incorporator mailed articles of incorporation to the secretary of state’s office. The articles were officially filed only after some unexplained delay. In the meanwhile, assuming that the articles had been filed and that the corporation existed, the shareholders entered into a lease on the corporation’s behalf. The lessor had considerable business experience, but did not require the shareholders to guarantee the lease personally. Instead, the lessor knew and expected that the corporation would be responsible for the lease. When the corporation failed to perform, lessor sought to hold the shareholders personally liable. The court held that, because of the delay in filing the articles, the business was not a legal corporation at the time the lease was made. The shareholders’ execution of articles of incorporation, the good faith effort to file them, and the carrying on of business in the corporation’s name, however, justified treating the firm as a de facto corporation. The shareholders therefore could not be held personally liable.[2]

---

[1] 398 A.2d 571 (N.J.App.Div.1979).

[2] Inactive investors present an even stronger case for invoking the de facto corporation doctrine and are rarely held personally liable for the firm’s obligations. See, e.g., Flanagan v. Jackson Wholesale Bldg. Supply Co., 461 So.2d 761, 765 (Miss.1984)(declining to hold inactive investor personally liable).

The Economist's latest piece in support of shareholder activism--First a quibble

The Economist is back boosting shareholder activism.

A quibble:

In America and a few other countries, boards can issue more shares without shareholder approval. In some countries, shareholders must approve issuance above a certain threshold. And in yet others, investors must agree before any new stock can be created.

Oddly, the Bartleby's column contradicts itself a couple of paragraphs later:

Another sign of agent-principal conflicts are shares that are privately placed with selected investors or used to pay for takeovers. In Australia any offering of more than 15% of the equity must be subject to shareholder approval; in America the threshold is 20%.

So which is it?

In fact, in the US, most public companies need shareholder approval for issuances "above a certain threshold." NYSE Listed Company Manual section 312.03(c) provides that, subject to certain exceptions, "Shareholder approval is required prior to the issuance of common stock, or of securities convertible into or exercisable for common stock, in any transaction or series of related transactions if: (1) the common stock has, or will have upon issuance, voting power equal to or in excess of 20 percent of the voting power outstanding before the issuance of such stock or of securities convertible into or exercisable for common stock; or (2) the number of shares of common stock to be issued is, or will be upon issuance, equal to or in excess of 20 percent of the number of shares of common stock outstanding before the issuance of the common stock or of securities convertible into or exercisable for common stock."

The NASDAQ has a similar rule for transactions not involving a public offering and various other issuances.

In addition to the stock exchange standards, a number of state corporation codes impose such requirements. Model Business Corporation Act section 6.21(f), for example, provides that:

An issuance of shares or other securities convertible into or rights exercisable for shares in a transaction or a series of integrated transactions requires approval of the shareholders, at a meeting at which a quorum consisting of a majority (or such greater number as the articles of incorporation may prescribe) of the votes entitled to be cast on the matter exists, if:

(i)  the shares, other securities, or rights are to be issued for consideration other than cash or cash equivalents, and

(ii)  the voting power of shares that are issued and issuable as a result of the transaction or series of integrated transactions will comprise more than 20% of the voting power of the shares of the corporation that were outstanding immediately before the transaction.

Delaware Chancery Court Flunks Target Firm's lawyers

From Francis Pileggi:

A recent Delaware Court of Chancery opinion began by describing the complaint as reading like a law school exam designed to test the knowledge of a student regarding the requirements in the DGCL that must be satisfied in connection with a merger, and the court commented that the company would not have done well on the exam. 

Chuckle. Go read the whole thing.

How do CEOs that are majority shareholders get outed as a CEO?

My answer to the titular question from Quora:

Short answer: They don’t.

Longer answer: The board may always oust the CEO, but if the CEO is also the majority shareholder, the CEO can simply use a written consent to remove the board of directors (I’m assuming Delaware law). The CEO would then elect new directors, who presumably would know which side of the bread their butter is on,

In theory, the incumbent board could try to take actions such as a dilutive stock issuance (Dilution Definition) to reduce the CEO’s holdings below 50%, but the legality of such actions absent serious misconduct by the CEO is suspect: “The board's fiduciary obligation to the corporation and its shareholders, in this setting, requires it to be a protective guardian of the rightful interest of the public shareholders. But while that obligation may authorize the board to take extraordinary steps to protect the minority from plain overreaching, it does not authorize the board to deploy corporate power against the majority stockholders, in the absence of a threatened serious breach of fiduciary duty by the controlling stock.” Mendel v. Carroll, 651 A.2d 297, 306 (Del. Ch. 1994). “In such an instance the board would bear a heavy burden to establish the justification for any steps purposely taken to affect the outcome of shareholder action.” Id. at 306 n.20.

Yours truly cited by Wisconsin Federal District Court re Rights of First Refusal

Dewey v. Bechthold, 18-CV-1739-JPS, 2019 WL 2193865, at *4 (E.D. Wis. May 21, 2019):

Although Wisconsin courts routinely uphold these types of provisions, some courts have held that rights-of-refusal should be narrowly construed. Frandsen v. Jensen-Sunquist Agency, Inc., 802 F.2d 941, 945–46 (7th Cir. 1986) (applying Wisconsin law and holding that a right-of-refusal is not triggered by a merger). Finally, it is worth noting that there is no legally mandated option price. Rather, the option price is set at the discretion of the corporation. See Nichols Constr. Corp. v. St. Clair, 708 F. Supp. 768, 771 (M.D. La. 1989), aff’d mem., 898 F.2d 150 (5th Cir. 1990) (holding that “the mere failure to pay ‘fair value’ for stock under a stock redemption agreement” is not “fraud or breach of fiduciary duty.”); F.B.I. Farms, Inc. v. Moore, 798 N.E.2d 440, 448 (Ind. 2003) (“to the extent that restriction devalues the shares in the hands of any individual shareholder by reason of lack of transferability, it is the result of the bargain they struck”); see also Stephen M. Bainbridge, Corporate Law, § 14.2 (3d ed. 2015) (explaining the aforesaid and noting that, where a right-of-refusal provision is in place, even option prices set at fair market value will be dramatically discounted by potential third party purchasers to account for the bargain’s low likelihood of success).

Macey and Strine on "Citizens United as Bad Corporate Law": Post 2-What about the shell game?

In closing my prior post on Macey & Strine's new article on Citizens United, I asked "do Strine and Macey really want to deny [individuals] the opportunity to assert their religious liberty simply because they incorporated their business?"

I raise this concern because, if accepted, Macey and Strine's approach would allow the government to restart what Douglas Laycock called the shell game:

The threshold issue in Sebelius v. Hobby Lobby Stores and Conestoga Wood Specialties Corp. v. Sebelius is whether any plaintiff’s free exercise of religion is substantially burdened within the meaning of the Religious Freedom Restoration Act.

On that issue, the government’s argument is a shell game. Only the individuals have religious-liberty rights; only the corporations are regulated. And more: Even the individuals have no rights when they act or refuse to act as directors, officers, or managers of the corporation. Not only are the individuals separate persons from the corporation, but the individuals are divided into additional separate persons, depending on the capacity in which they act. This is formalism in the extreme.

Douglas Laycock, Symposium: Congress answered this question: Corporations are covered, SCOTUSblog (Feb. 19, 2014), http://www.scotusblog.com/2014/02/symposium-congress-answered-this-question-corporations-are-covered/.

The shell game thus eviscerates essential rights, as I noted in in my article, Using Reverse Veil Piercing to Vindicate the Free Exercise Rights of Incorporated Employers (March 6, 2013). The Green Bag, Vol. 16, No. 3, Spring 2013, available at SSRN: https://ssrn.com/abstract=2229414,

Conduct that is motivated by religious belief is accepted as one of the ways in which people exercise their religious freedom, however, even when the conduct occurs in a commercial setting. ... The values protected by the religious freedom clauses of the First Amendment “have been zealously protected, sometimes even at the expense of other interests of admittedly high social importance.” Accordingly, “no official, high or petty, can prescribe what shall be orthodox in politics, nationalism, religion, or other matters of opin- ion or force citizens to confess by word or act their faith therein.”

I would feel better about Macey & Strine's project if they explained just how their approach would ensure that people conducting their business as a corporation would still find those rights protected. Or perhaps explain why the shell game isn't a concern.

Macey and Strine on "Citizens United as Bad Corporate Law": Post 1-What about Close Corporations

I am reading with great interest Jonathan R. Macey and Leo E. Strine, Citizens United As Bad Corporate Law (August 16, 2018), https://ssrn.com/abstract=3233118. Herewith the absurdly long abstract:

In this Article we show that Citizens United v. FEC, arguably the most important First Amendment case of the new millennium, is predicated on a fundamental misconception about the nature of the corporation. Specifically, Citizens United v. FEC, which prohibited the government from restricting independent expenditures for corporate communications, and held that corporations enjoy the same free speech rights to engage in political spending as human citizens, is grounded on the erroneous theory that corporations are “associations of citizens” rather than what they actually are: independent legal entities distinct from those who own their stock. Our contribution to the literature on Citizens United is that the case is as much a case about corporate law, as it is about the First Amendment. The major disagreement among the justices in Citizens United is about the applicability of settled First Amendment protections to a particular juridical entity, the corporation. In Citizens United, Justice Kennedy, writing for the majority opines that Congress may not take into account the distinctions between corporations and human beings in regulating political speech, and that corporations must be permitted the same freedom to speak as human beings. In dissent, Justice Stevens fails directly to challenge Justice Kennedy’s existential conception of the corporation notwithstanding the fact that that it constitutes the core of the majority opinion. This Article fills that void. We reject the Citizens United majority’s conception of the corporation as an “associations of citizens” and reaffirm its status as an artificial, metaphysical, and legal construct that exists separate and apart from its investors. The Citizens United view of the corporation as an association of individuals is inconsistent with the established conception of the corporation as a juridical entity with limited liability.

This conception confuses the corporation with the general partnership form of business organization. In fact, the entire point of the incorporation process is to permit the creation of a legal entity that is not an association of individuals, but rather a discrete legal entity whose rights and obligations are distinct from those of it its creators, investors, managers, and other constituents. We base our argument that corporations are separate and distinct legal entities and that they are not “associations of citizens” as Citizens United asserts on three facts about the corporate form:

(1) the treatment of corporations as separate legal entities is what distinguishes corporations from general partnerships and sole proprietorships and what justifies the legal notion of “limited liability” and other central characteristics of the corporate form, such as the ability to contract and to sue and be sued;

(2) corporations do not have owners, they have investors who have contract-based, financial interests in the firms and limited management rights; and

(3) corporations are not fiction, but fact only because the law makes them real and distinct entities with a legal identity.

In Part I of this Article, we discuss the nature of the corporate form by describing its core attributes and explain that one must infer from the nature of the corporate form itself that the corporation is an entity, not an association of individuals. In Part II, we expand upon the analysis in Part I by examining certain settled legal characteristics that the Supreme Court has itself recognized to distinguish the corporation from other forms of business organization that can more plausibly be viewed as associations of individuals. We conclude Part II by noting a simple, empirical reality that cuts against Citizens United’s conception of the corporation as an “association of citizens”: stockholders are not owners of the corporation, but rather contract claimants. In Part III, we discuss the reality that in most other areas of its jurisprudence the Supreme Court embraces the traditional entity view of the corporation, and does not treat corporations as associations of citizens. Thus, Citizens United and its progeny are outliers, in tension with the Supreme Court’s decisional law in key areas like standing, tax law, criminal law, and other areas of constitutional law.

Our analysis shows that in the great bulk of its jurisprudence, the Supreme Court adheres to our view of the business corporation, which is that it is a distinct legal entity whose rights and obligations are subject to statutory constraint. In fact, by long tradition, starting under Chief Justice Marshall, corporations are the opposite of Lockean–Jeffersonian human beings endowed with inalienable rights that cannot be taken away by the government. By contrast, corporations have only those rights society gives them by statutory law, and any statutory law may take into account the unique nature of corporations in limiting their ability to act. We then point out in Part IV profound problems with Citizen United’s assertion that corporations are “associations of citizens.” Namely, that assertion comes without supporting legal authority and for good reason. Neither the law nor empirical fact supports the idea that stockholders are associated citizens, much less with any common political or social viewpoint. Part V then notes the stark difference in the Supreme Court’s approach when dealing with the free speech of labor unions. In the union context, the Supreme Court’s principal concern has been ensuring that no union member has his dues used for political speech without his express authorization, and has held that it is a First Amendment violation to use union dues for political speech.

Just this year, in Janus v. American Federation of State, County, and Municipal Employees, Council 31 the Court went further and held that unions could not even collect fees for the costs due to the core costs of bargaining for higher wages from a workforce member who did not join the union. In McCain-Feingold, Congress embraced concerns like this and gave corporations the ability to engage in political speech by raising funds voluntarily from stockholders for this purpose. This means took into account the corporate law consensus that stockholders’ decision to invest in business corporations does not rationally involve any authorization for the corporation to use treasury funds for political speech, and that stockholders are of diverse political viewpoints and only have a shared interest in one thing, getting a good return on their investment. But, applying a starkly different viewpoint than it takes in cases like Abood and Janus, the Supreme Court struck down McCain-Feingold and trivialized the substantial leeway McCain-Feingold had given for corporations to speak. In analyzing this contradiction, we identify the market realities that make it even less plausible that 21st century American business corporations can be deemed “associations of citizens,” especially when most of their stock is owned by institutional investors, to whom American investors are in essence compelled to turn over their capital to save for college for their kids and retirement for themselves. And we conclude Part II by noting a simple, empirical realty that cuts against Citizens United’s conception of the corporation as an “association of citizens”: stockholders are not owners of the corporation, but rather contract claimants.

Finally, in Part VI we comment on the lack of any source for the Citizens United majority’s view that the corporation is an association of individuals. In particular, we observe that corporations are creatures of state law, not federal law. As the Court observed in CTS Corp. v. Dynamics Corp., “[s]tate regulation of corporate governance is regulation of entities whose very existence and attributes are a product of state law.” Therefore, determinations about the nature of the corporation, such as whether the corporation is a distinct juridical entity or an association of individuals, should be made by reference to state law, not federal law. To further this point, we survey those forms of entities that might be more plausibly considered associational in form than corporations, and note that in the main, most of them are trending strongly toward the entity conception. After doing so, we address those corporations most rationally considered to be vehicles for the shared viewed points of those who form them: non-profit corporations. As to them, we highlight two features that buttress our core point. To wit, most non-profit corporations are member corporations and do not even have stockholders. And as important, these corporations do not fund their speech using the entrusted capital of their members or stockholders. Rather, they speak using funds they raise specifically for that purpose from donors—exactly the method that Congress left open to corporations in McCain-Feingold and that the Citizens United majority said constituted a total ban on corporate speech. We conclude by noticing an irony. It was the legislative branch, not the judicial branch that is supposedly more learned in the law, that was the one that understood corporate law when addressing political speech. Congress considered the nature of corporations when enacting McCain-Feingold and took into account that corporations are not associations of citizens, but separate, state-created entities formed for reasons that cannot be rationally attributed to the shared political or philosophical views of their investors. As such, Congress allowed corporations broad freedom to engage in political speech, but only by using funds voluntarily contributed for this purpose by stockholders to a corporate-controlled political action committee (PAC). By this means, Congress left ample room for the corporation to act as a collective vehicle for stockholders who wished to affiliate for that purpose, but protected other stockholders from being forced to subsidize speech that the mere decision to invest cannot plausibly be thought to endorse. By contrast, the Supreme Court ignored, or misunderstood, the traditional corporate law concept of the corporation and thereby subjected millions of American investors to suffer the involuntary use of their entrusted capital for speech that has no rational connection to their decision to buy stock. That is bad corporate law making bad constitutional law.

When a deservedly distinguished Yale law professor and the Chief Justice of the Delaware Supreme Court speaks, we lesser mortals do well to tread lightly. Yet, I am moved to offer a few thoughts.

First, a quibble. Macey and Strine spend a great deal of time arguing that shareholders are heterogenous, that corporations are board-centric, that shareholders do not own the corporation, and so on and on. Their point, of course, is that "a corporation is a separate entity distinct from its shareholders." Virtually all of their arguments, however, apply almost exclusively to publicly held corporations. 

But what about the millions of close corporations? They are relegated to essentially a single footnote (151):

In some of its jurisprudence dealing with entities, the Supreme Court seems tempted to give greater credence to arguments by closely held business corporations arguing that they should be able to make claims to constitutional protection, such as in arguing that a corporation’s religious freedom has been impinged, than it would indulge from a public corporation. See Burwell v. Hobby Lobby Stores, Inc., 134 S. Ct. 2751 (2014) (holding that the Affordable Care Act contraception mandate, as applied to a closely held for-profit corporation, violated the Religious Freedom Restoration Act). Even corporate law scholars sympathetic to the notion that all corporations should be able to advance such claims view it as bad corporate law to use the number of stockholders as a dividing line for the exercise of rights. Brief for Corporate and Criminal Law Professors as Amici Curiae Supporting Petitioners, Burwell v. Hobby Lobby Stores, Inc., 134 S. Ct. 2751 (2014) (Nos. 13-354, 13-356), 2014 WL 333889. The reason for that is inarguable: corporate law itself makes no distinction on this ground and there is little basis to believe that the stockholders of more closely held businesses tend to be more united around a religious or other non-monetary purpose than those of public corporations. Their argument for the corporate exercise of rights is simple and different: they contend that corporate boards are elected and have broad discretion while in office to advance any lawful purpose, unless constrained by the charter from doing so. Lyman P.Q. Johnson and David K. Millon, Corporate Law After Hobby Lobby, 70 BUS. LAW. 1, 10 (2015) (“State corporate law does not require corporations to prioritize profits over competing considerations. This fact has ramifications that extend far beyond the particular activities—religious observance—at issue in the Hobby Lobby cases. All business corporations (and non-profits too, for that matter) must generate profit in order to survive. That is simply a fact of life. But corporate law confers on [boards] broad discretion to determine the extent to which they choose to temper the pursuit of profit by regard for other values.”). But see Stephen M. Bainbridge, A Critique of the Corporate Law Professors’ Amicus Brief in Hobby Lobby andConestoga Wood, 100 VA. L. REV. ONLINE 1, 4–5 (2014) (“The law thus has long recognized William Klein’s point that, despite the utility of the fiction of corporate legal personhood, it is critical to remember that treating the corporation as an entity separate from the people making it up bears no relation to economic reality.”). They do not conflate the corporation with its stockholders or view it as an association of them. Rather, these scholars just believe corporations, although distinct from their human constituents, should have all the rights of human beings, while recognizing that they do not have all of the obligations that come from being a human citizen.

I genuinely struggle with this paragraph, but I take it that their core point is captured by the statement that "there is little basis to believe that the stockholders of more closely held businesses tend to be more united around a religious or other non-monetary purpose than those of public corporations."

Says who?

Other courts have disagreed. Consider, for example, Tyndale House Publishers, Inc. v . Sebelius, 2012 WL 5817323 at *2 (D .D .C. 2012), in which the Court wrote that:

Tyndale is a closely-held corporation owned by four entities united by their Christian faith, each of which plays a distinct role in achieving shared, religious objectives. Christian principles, prayer, and activities are pervasive at Tyndale, and the company’s ownership structure is designed to en- sure that it never strays from its faith-oriented mission. . . . Tyndale’s religious objection to providing insurance cover age for certain contraceptives reflects the beliefs of Tyn- dale’s owners. Nor is there any dispute that Tyndale’s primary owner, the Foundation, can “exercise religion” in its own right, given that it is a non-profit religious organization . . . . Accordingly, because Tyndale does “not present any free exercise rights of its own different from or greater than its owners’ rights,” it has “standing to assert the free exercise rights of its owners.”

I also take issue with the empirical claim. See, e.g., Frederick H. Alexander, Lawrence A. Hamermesh, Frank R. Martin, Norman M. & Monhait, M&A Under Delaware's Public Benefit Corporation Statute: A Hypothetical Tour, 4 Harv. Bus. L. Rev. 255, 279 (2014) (pointing out that benefit corporations are often "closely held by a cohesive group of like-minded stockholders with similar preferences").

Finally, in my article, Using Reverse Veil Piercing to Vindicate the Free Exercise Rights of Incorporated Employers (March 6, 2013). The Green Bag, Vol. 16, No. 3, Spring 2013, available at SSRN: https://ssrn.com/abstract=2229414, I offer a test designed to find out precisely whether the stockholders of a closely held businesses are "united around a religious or other non-monetary purpose." If they are, do Strine and Macey really want to deny them the opportunity to assert their religious liberty simply because they incorporated their business?

What is the difference between a chief executive officer and a chairman?

My answer to a Quora question:

The chief executive officer is “A corporation's highest-ranking administrator or manager, who reports to the board of directors.” CHIEF EXECUTIVE OFFICER, Black's Law Dictionary (10th ed. 2014).

The chairman is “The preeminent member of a board of directors, responsible for leading the firm's other officers and executives, presiding over board meetings, and ensuring that the firm's duties to shareholders are being fulfilled by acting as a link between the board and the upper management.” CHAIR OF THE BOARD, Black's Law Dictionary (10th ed. 2014).

“Chairman Williams stressed the different roles that the chair and CEO have to perform: ‘[I]n the board environment, the role of the chairman . . . is to create the kind of open, contributing and questioning environment . . . The CEO's role is to speak for management.’” Joel Seligman, A Modest Revolution in Corporate Governance, 80 Notre Dame L. Rev. 1159, 1176 (2005).

“The roles of the chairman and CEO can be seen as encompassing different domains that may not be complementary, particularly if one of the roles of the chair is as a mentor and reality check for the CEO, and as a focal point for providing information to the board as a whole.” Mark A. Fox et. al., Corporate Governance Research on New Zealand Listed Companies, 29 Ariz. J. Intl. & Comp. L. 1, 31 (2012)

I'm no Google fan, but this lawsuit alleging breach of fiduciary duty by its directors strikes even mean weak

Bloomberg reports:

Google’s top brass face claims they shirked their duties to shareholders by fostering a “culture of misconduct” that exposed the company to a wave of scandals and lawsuits.

The “uninformed and uninvolved” directors of Google parent Alphabet Inc. deferred to its star-studded leadership team, giving the company’s co-founders and their lieutenants leeway to run their divisions with little board oversight, according to a complaint unsealed May 20 in Delaware Chancery Court.

“This culture that fostered autonomy, however, also led to systematic sex and age discrimination, sexual misconduct perpetrated by high-ranking executives, and a disregard for protecting user privacy,” the partly redacted suit says.

The “dark underside of Google’s culture” is responsible for multiple class actions over its privacy practices, unequal pay for women, age discrimination, and sexual harassment, according to the 70-page complaint, which was filed under seal May 14.

Here's the complaint.

At it's core, it's a Caremark claim. For an overview of Caremark, see this post. 

In Stone v. Ritter, the Delaware supreme court confirmed that “Caremark articulates the necessary conditions for assessing director oversight liability.” In doing so, however, the court described Caremark as a case in which the operative standards are good faith and loyalty rather than care, stating that:

[T]he Caremark standard for so-called “oversight” liability draws heavily upon the concept of director failure to act in good faith. That is consistent with the definition(s) of bad faith recently approved by this Court in its recent Disney decision, where we held that a failure to act in good faith requires conduct that is qualitatively different from, and more culpable than, the conduct giving rise to a violation of the fiduciary duty of care (i.e., gross negligence). In Disney, we identified the following examples of conduct that would establish a failure to act in good faith: . . . where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.

Stone further held that “In the absence of red flags, good faith in the context of oversight must be measured by the directors’ actions to assure a reasonable information and reporting system exists and not by second-guessing after the occurrence of employee conduct that results in an unintended adverse outcome.” Liability will arise only where there are alleged “red flags” that are “either waved in one’s face or displayed so that they are visible to the careful observer.” Rattner v. Bidzos, 2003 WL 22284323 at 13 (Del. Ch. 2003), quoting In re Citigroup Inc. S’holders Litig., 2003 WL 21384599, at *2 (Del. Ch. 2003). Stringing together a bunch of negative news reports does not amount to the necessary red flags.

Caremark claims are notoriously the most difficult corporate law claim fora plaintiff to establish (see here). So good luck.

Centros, California’s Women on Boards Statute and the Scope of Regulatory Competition

There's a really interesting new article by Jill Fisch and Steven Davidoff Solomon:

We examine the Centros decision through the lens of SB 826 – the California statute mandating a minimum number of women on boards. SB 826, like the Centros decision, raises questions about the scope of the internal affairs doctrine and its role in encouraging regulatory competition. Despite the claim that US corporate law is characterized by regulatory competition, in the US, the internal affairs doctrine has led to less variation in corporate law than in Europe. We theorize that this is due to the shareholder primacy norm in US corporate law which results in the internal affairs doctrine focusing on matters of shareholder interest and, primarily, shareholder economic interest. We argue that the internal affairs doctrine should be understood within the context of the shareholder primacy norm and therefore directed to rules oriented to enhancing firm economic value. In contrast, EU corporate law has traditionally had broader stakeholder orientation. We posit that the limited impact of the Centros decision, an impact which differed significantly from its predicted revolutionary effect, can be attributed to the greater focus of EU corporate law on social ordering and extra-shareholder interests. This difference leads to a new understanding of SB 826 as reflecting a move toward more EU-style governance focused on social ordering. Ironically, California’s adoption of SB 826 may portend a movement of the United States towards Centros-style governance. Under this analysis, we argue that SB 826 should not be viewed as inconsistent with the internal affairs doctrine since it involves social ordering rather than purely shareholder interests.

Fisch, Jill E. and Davidoff Solomon, Steven, Centros, California’s 'Women on Boards' Statute and the Scope of Regulatory Competition (May 7, 2019). European Business Organization Law Review (Forthcoming).; U of Penn, Inst for Law & Econ Research Paper No. 19-23. Available at SSRN: https://ssrn.com/abstract=3384768

What, you may be asking, is this Centros decision of which they speak? From the Columbia Journal of European Law:

In 1999 the European Court of Justice (the “ECJ”) handed down its decision in the now famous case of Centros Ltd v. Erhvervs- og Selskabsstyrelsen. The case concerned the ability of two Danish nationals to incorporate their company in the UK without carrying out any business there for the purpose of operating their company in Denmark through a “branch,” all the while skirting Danish rules on minimum capitalization. Despite the Danish government’s protestations that this constituted blatant fraud and endangered creditors, the ECJ held that the Danish nationals’ scheme was permissible under the right to freedom of establishment as guaranteed by the EC Treaty.

Centros, in the words of one commentator, immediately provoked “great waves of unrest on the continent.” To understand why this is so, it is necessary to understand the system of conflict-of-laws approaches within Europe – a system which at this point rises to the level of deeply held convictions. Although the ECJ did not explicitly address conflict-of-laws in Centros, many commentators have argued that the case has serious implications for this issue.

The Netherlands, the UK, Ireland and Denmark subscribe to incorporation theory in their conflict-of-laws legislation, while the rest of Europe subscribes to the system of siège réel, or seat theory. As far as the Netherlands, the UK, Ireland and Denmark are concerned, they are willing to recognize any corporation as a legal entity so long as it has been duly incorporated under the laws of a particular jurisdiction. The rest of Europe, however, insists that a company’s legal personality be bound to the place of its “real seat,” or central administration. Therefore, a duly incorporated company seeking to locate its central administration in a seat theory state will not be recognized legally until it reincorporates itself under that state’s laws.

For years, seat theory has guaranteed those countries that adhere to it effective control over the businesses whose activities concentrate within their borders. Indeed, seat theory is designed as a first line of defense against corporations governed by (presumably less stringent) foreign laws. It has also effectively prevented the prospect of regulatory competition within the European Union (the “EU”) in the area of company law.

Should Congress or the SEC Regulate Stock Buybacks?

I commend to your attention a CLS Blue Sky blog post by George Ugeux, which makes some interesting points.

First, he makes the point that the differential tax treatment of dividends and stock buybacks is all that really differentiates the two, which raises the pertinent question of why people like Senator warren are so worked up about them. In addition, the recent surge in stock buybacks is probably Congress' fault, since it is probably linked to the recent tax cuts.

Second, "a share buyback is a recognition that the company does not have anything better to do with its money than return it to shareholders." In other words, when people like Senator Warren advocate restricting stock buybacks, they are essentially arguing that corporations should make negative net present value investments. See generally Jensen, Michael C. "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers." The American Economic Review 76, no. 2 (1986): 323-29. http://www.jstor.org/stable/1818789 

Third, he argues that:

Despite the good intentions of politicians who aim to limit or even ban buybacks, the issue is much more nuanced. ...

The SEC polices the fairness and the transparency of corporate actions. The capital increase of a listed company is accompanied by an underwriting process, due diligence, and justification of the board in a prospectus. Share buybacks deserve similar transparency and authorization requirements – perhaps more than under the current Rule 10B-18 regime that covers buybacks. The SEC is right to assess the wider implications of buybacks.

There's an error in there and also a misapprehension. As to the error, in general, the SEC is not allowed to regulate the substantive fairness of transactions. Consider that when the SEC adopted its going private rule, it did not adopt a proposal "that would have gone beyond disclosure requirements and placed substantive fairness limitations on an issuer's attempt to go private." § 48.3.Federal regulation of going private transactions, 20 Ind. Prac., Business Organizations § 48.3. As another example, the Supreme Court has consistency described "the ‘fundamental purpose’ of the [Securities Exchange] Act as implementing a ‘philosophy of full disclosure’; once full and fair disclosure has occurred, the fairness of the terms of the transaction is at most a tangential concern of the statute." Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 477–78 (1977). "The SEC has no authority to decide whether a particular security may be offered to the public or if the terms of an offering are fair; it can only insist that the issuer make full disclosure of all material facts." Stephen H. Case & Mitchell A., Current Issues in Prepackaged Chapter 11 Plans of Reorganization and Using the Federal Declaratory Judgment Act for Instant Reorganizations, 1991 Ann. Surv. Am. L. 75, 121 (1992).

The misapprehension is that the SEC is somehow a nonpartisan regulator. As Roberta Karmel observes, however: "The SEC is supposed to be a collegial agency of nonpartisan experts. Instead it has become an agency riven by partisanship due to politicians trying to score points and gain publicity." Roberta S. Karmel, Threats to the SEC's Independence, 2016 Bus. L. Today 1, 3 (December 2016). 

Case note on Verition Partners Master Fund Ltd. v. Aruba Networks, Inc.

Delaware Supreme Court Clarifies Appraisal Law https://t.co/5cOUFtIllt Case note on Verition Partners Master Fund Ltd. v. Aruba Networks, Inc.

— Professor Bainbridge (@ProfBainbridge) May 1, 2019

Kahn v. MFW requires controller self-disablement early

Delaware Supreme Court Clarifies Ab Initio Requirement for BJR Review https://t.co/HAgLzLGQJM Controller must self-disable before substantive economic bargaining starts

— Professor Bainbridge (@ProfBainbridge) May 1, 2019

Delaware Chief Justice Leo Strine on independent directors--I've been saying the same thing for years

From an interview of Strine at Directors & Boards:

We have a lot of unrealistic expectations for independent directors, and I think it would be better to rebalance boards a little bit. We need folks who are genuinely independent directors, but we also need directors with expertise, and we need directors who were active in business and who understand the industry. And some of the rules and incentives can get so tight that we actually discourage people with the right kind of qualities from serving on boards.

It doesn’t really matter if you’re independent if you don’t have expertise. But can you be independent and also have the expertise and the knowledge? I’m sure you can.

We just independent directorized the world. We went from having a bare majority of them to having a supermajority of them. We don’t actually empower them. We take away their ability to think long term because we put in place Say on Pay. We don’t do Say on Pay every four years or five years, where you would really have a long-term pay plan, we do it every year as a vote on generalized outrage.

Independent directors are not like trustees at universities, who usually have prior affiliations with the university and the community in which it exists, and that they care deeply about. Independent directors are weather vanes for the market. Not to denigrate them, but let’s think about the definition of an independent director. They tend to have no prior affiliation or current association with the company, and thus they really have no reason to deeply care about it or any aspect of it. Now you can say that’s independence, but it’s also a blank slate.

There’s great competition to be an independent director. Independent director pay has gone up. The typical pay just to be on one company board is higher than my judges in our judiciary. If you’re on three boards, you’re often making more than a half million dollars a year just as a director.

The old concern was that directors had to be popular with management to stay on boards, but now you have to stay popular with the institutional investor community and with the proxy advisers, and therefore these directors are highly responsive to market sentiment.

Maybe my lack of popularity with the self-appointed shareholder spokesmen who run ISS and its ilk, not to mention institutional investors generally explains my lack of board seats?

Anyway, the usually board-bashing/activist-loving folks at The Corporate Counsel observe that:

It’s refreshing to hear somebody with influence in the corporate governance debate finally say something like this. As I’ve blogged previously, my guess is that in 50 years people may really wonder why we thought it was a good idea to demand that the boards of the world’s largest corporations be comprised overwhelmingly of people with no ties to or experience with the company. Who knows? Maybe Chief Justice Strine’s remarks are a signal that we won’t have to wait 50 years for people to start asking that question.

I've been a sharp critic of independent director mandates going back to one of my first articles, see Independent Directors and the ALI Corporate Governance Project, 61 Geo. Wash. L. Rev. 1034 (1992). In my book Corporate Governance after the Financial Crisis, I wrote that:

... the board of directors has three basic functions. First, while boards rarely are involved in day-to-day operational decision making, most boards have at least some managerial functions. Second, the board provides networking and other services. Finally, the board monitors and disciplines top management.

Independence is potentially relevant to all three board functions. As to the former two, outside directors provide both their own expertise and interlocks with diverse contact networks. As to the latter, at least according to conventional wisdom, board independence is an important device for constraining agency costs. On close examination, however, neither rationale for board independence justifies the sort of one size fits all mandate adopted by the exchanges at the behest of Congress and the SEC.

After a lengthy review of the evidence on director independence, I concluded that "the empirical evidence on the merits of board independence is mixed." I then observed that:

The fetish for board independence has costs. Two are already on the table; namely, those associated with the information asymmetry between outsiders and insiders and those occasioned by the need to incent outsiders to perform. A third is the lost value of insider representation.

Oliver Williamson suggests that one of the board’s functions is to “safeguard the contractual relation between the firm and its management.”[1] Insider board representation may be necessary to carry out that function. Many adverse firm outcomes are beyond management’s control. If the board is limited to monitoring management, and especially if it is limited to objective measures of performance, however, the board may be unable to differentiate between acts of god, bad luck, ineptitude, and self-dealing. As a result, risk averse managers may demand a higher return to compensate them for the risk that the board will be unable to make such distinctions. Alternatively, managers may reduce the extent of their investments in firm-specific human capital, so as to minimize nondiversifiable employment risk. Insider representation on the board may avoid those problems by providing better information and insight into the causes of adverse outcomes.

Insider representation on the board also will encourage learned trust between insiders and outsiders. Insider representation on the board thus provides the board with a credible source of information necessary to accurate subjective assessment of managerial performance. In addition, however, it also serves as a bond between the firm and the top management team. Insider directors presumably will look out for their own interests and those of their fellow managers. Board representation thus offers some protection against dismissal for adverse outcomes outside management’s control.

Such considerations likely explain the finding by Klein of a positive correlation between the presence of insiders on board committees and firm performance.[2] They also help explain the finding by Wagner et al. that increasing the number of insiders on the board is positively correlated with firm performance.[3]

The fetish for independence cost us these potential benefits from insider representation. Congress’ refusal to permit private ordering means that those firms where those costs are highest are unable to opt out of the one size fits all straightjacket.

"Is a board of directors absolutely mandatory in a corporation/company?"

I offered the following answer to the titular question at Quora:

Section 8.01(a) of the Model Business Corporation Act (in force in over 2/3 of the states) provides that: “Except as may be provided in an agreement authorized under section 7.32, each corporation shall have a board of directors.”

In turn, section 7.32(a) provides that: “An agreement among the shareholders of a corporation that complies with this section is effective among the shareholders and the corporation even though it is inconsistent with one or more other provisions of this Act in that it: (1) eliminates the board of directors ….”

Note, however, that such an agreement must be unanimous and be made known to the corporation. It must be disclosed on share certificates.

If the agreement eliminates the board of directors, there is no prescribed replacement. As the Official Comment to section 8.01(a) states, “the shareholders of a corporation may, in an agreement that satisfies the requirements of section 7.32, dispense with a board of directors and structure the corporation’s management and governance to address specific needs of the enterprise.”

Although section 7.32 is not limited to closely held corporations, many states have limited the option of eliminating the bard of directors to closely held corporations.

Indeed, it is essentially unheard of for publicly held corporations to have such agreements and equally unheard of for publicly held corporations to eliminate the board. See, e.g., POST PROPERTIES, INC., SEC No Action Ltrs. WSB File No. 0329200417 (“It is inconceivable, for example, that shareholders of a publicly-traded company such as Post Properties would attempt to eliminate the board of directors entirely, to designate an outside person to manage its business, or to give to one of its shareholders the power to cause corporate dissolution. These limits are totally incompatible with public ownership ….”

Delaware General Corporation Law section 141(a) provides that: “The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation. If any such provision is made in the certificate of incorporation, the powers and duties conferred or imposed upon the board of directors by this chapter shall be exercised or performed to such extent and by such person or persons as shall be provided in the certificate of incorporation.”